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Stock picking, plain and simple. And successful. That's what attracts investors -- individuals, private-wealth managers, and endowments -- to Lateef Investment Management, a $4.5 billion money-management firm in Greenbrae, Calif., a small Marin County town just north of San Francisco. Three portfolio managers, Quoc Tran, James Tarkenton, and Matthew Sauer, scour and sift for underappreciated and mispriced blue-chip companies with strong balance sheets, strong business models, high free-cash flows, and attractive returns on capital. The trio is steeped in the art of value investing, having learned it from some of the best in the business, including Wally Weitz of Weitz Funds and John Rogers of Ariel Investments. Their flagship offering, the
Lateef Fund
(ticker: LIMAX), celebrated its fifth anniversary at year end by doing what it's usually done: beating its benchmark.

Barron's:Are you more bullish or bearish about the U.S. equity market after the run-up in the S&P 500 and Dow Jones industrials?

Sauer: You can almost feel the rumbling of what they are calling the "great rotation" into equities. We're seeing it in fund flows. Corporate risk spreads are obviously tight. Junk-bond yields are low. That is positive for the market.

In the past few years, there have been moments when we've seen individual investors start to move back to equities, only to get spooked and return to bonds. Why is this time different?

Sauer: Government bonds have continued to go down in yield. The economic environment is more positive, and credit spreads on corporate bonds are narrowing. When you see the junk market rallying, a market of equity-like bonds, it's no wonder the Dow is approaching new highs. That rally will be a bell for some investors to get back into equities. If the Fed continues to keep rates low, and the war on cash continues, people are going to start to take more risk.

From left, Sauer, Tarkenton, Tran. "We own 15 to 20 growth stocks, with managements we respect...selling at 20% to 50% discounts."
Martin Klimek for Barron's

Tarkenton: From a psychological standpoint, another big component of investors' net worth is their homes, and as pricing turns up there and as we get closer to setting new highs in the equity market, it will drive the individual investor to take more risk.

Tran: In any form of investment, whether it is in fixed income or equities, you are buying a stream of future cash flow. Using the 10-year Treasury as a proxy, you are getting 2% or less in total return. In the equity markets, at least in our portfolio, you are getting a trailing-free-cash-flow yield of 6% and growth in the midteens, we estimate, for the next three to five years. So you have an attractive absolute return today with growth, as opposed to a total return of 2% in the bond market. In terms of asset flows over the past four years, a trillion dollars moved into fixed income and about half a trillion came out of equities. Retail investors are coming back to equities in fits and starts, and only time will tell if this is the beginning of a truly long set of inflows. But it certainly feels much more constructive now than at any point in the past four years.

Also, we follow the asset allocation of pension funds, retirement accounts, and college endowments. Five years ago, it was pretty typical for these groups to have 60% allocated to equities. Now, that asset allocation has been reduced to about 30%, and yet these funds are still assuming a rate of return of 8%. In this low-interest-rate environment, that's mathematically impossible. They will need to raise their equity allocations in order to get to mid-to-high single-digit returns to meet their funding obligations.

We've got higher taxes. We are still dealing with the debt-ceiling issue. Europe is still struggling. How do those issues stack up against the positive catalysts?

Tarkenton: The core tenets of our investment criteria drive and build a portfolio of very attractive returns, earnings, cash flows, and return on equity. Even in 2008, in an extremely dislocated economic environment, our portfolio grew its earnings 13% while S&P 500 earnings were down over 40%, and the return on equity on our portfolio of companies was 24%, versus 12% for the S&P 500. We definitely want to be mindful of the economic environment in which we are allocating our clients' capital, but by sticking to our criteria, we think our portfolio will continue to have those types of growth rates and performance.

Sauer: We don't try to own the whole market: We own 15 to 20 growth stocks -- with managements we respect who are allocating capital appropriately -- selling at 20% to 50% discounts to what we think they are worth.

Why the concentration?

Tarkenton: You have to have conviction in your top ideas. Our top four names in the portfolio represent 32% of assets, and our top 10 names are 70% of assets. The investment criteria that drive our decision-making generate a portfolio with less risk relative to the market and with earnings growth and returns and general characteristics that are more attractive than the market.

Sauer: In order to beat an index, you have to look different than the index. Our portfolio and the way we construct it gives us the freedom to do things like sell
Appleaapl 0.09295840111550081%Apple Inc.U.S.: NasdaqUSD129.21
0.120.09295840111550081%
/Date(1425417962617-0600)/
Volume (Delayed 15m)
:
31588565
P/E Ratio
17.278447121820616Market Cap
751916704040.229
Dividend Yield
1.456573952119005% Rev. per Employee
2153110More quote details and news »aaplinYour ValueYour ChangeShort position
[AAPL] in the second quarter of last year, when all the portfolios in the U.S., it seems, held Apple. It was obviously a very popular stock at the time, but we saw Apple's prospects differently than the consensus.

Do your criteria rule out or favor certain industries?

Tarkenton: Business services is an area where we find a lot of our opportunities. These are companies with few assets and [that are] not capital intensive.

Tran: Also, heavily regulated businesses where you have a regulated rate of return are not going to be a high priority for us. You will see us in a lot of consumer-discretionary names. You are going to see us in some tech and in some B2B [business-to-business companies]. Intellectual capital companies are attractive, too.

Intellectual capital such as?

Tran: Qualcommqcom -1.5071227031862913%Qualcomm Inc.U.S.: NasdaqUSD71.56
-1.095-1.5071227031862913%
/Date(1425417960716-0600)/
Volume (Delayed 15m)
:
6399692
P/E Ratio
14.893970893970893Market Cap
119848784043.506
Dividend Yield
2.3450586264656614% Rev. per Employee
861470More quote details and news »qcominYour ValueYour ChangeShort position
[QCOM]. Qualcomm has two segments: They invented CDMA, which is the technology that enables 3G and smartphones to work. They also have a licensing business where they get a royalty on every smartphone in the world. Qualcomm wins if Apple wins, or if
MicrosoftMSFT -1.5268915223336372%Microsoft Corp.U.S.: NasdaqUSD43.21
-0.67-1.5268915223336372%
/Date(1425417962442-0600)/
Volume (Delayed 15m)
:
22118931
P/E Ratio
17.304Market Cap
359982101418.838
Dividend Yield
2.8663892741562647% Rev. per Employee
728656More quote details and news »MSFTinYour ValueYour ChangeShort position
[MSFT] wins, or if Android [made by
GoogleGOOG 0.4690727062694718%Google Inc. Cl CU.S.: NasdaqUSD574.02
2.680.4690727062694718%
/Date(1425417940989-0600)/
Volume (Delayed 15m)
:
1343314
P/E Ratio
28.294671186708314Market Cap
390118128469.246
Dividend Yield
N/ARev. per Employee
1228170More quote details and news »GOOGinYour ValueYour ChangeShort position
(GOOG)] wins. The stream of licensing revenue is highly profitable with margins of 85% in that segment. Qualcomm generates returns on capital of more than 50% and has a very high barrier to entry because of the patents on those licenses. The stock is about $67 a share; there is $15 a share in cash and no debt. They'll earn about $4.40 this year on a calendar basis, and adjusting for cash, Qualcomm is selling at about 11 times earnings. We think the intrinsic value is $85 to $90 a share.

Lateef's Picks

Recent

Company

Ticker

Price

Qualcomm

QCOM

$66.54

Stanley Black & Decker

SWK

76.30

Robert Half

RHI

35.55

Waters Corp.

WAT

91.40

Starwood Hotels & Resorts Worldwide

HOT

61.72

EMC

EMC

24.75

Source: Bloomberg

Tarkenton: This is a very stable growth business, and with the growth in mobility, it is almost an open-ended opportunity.

European companies are trading at a steep discount to their U.S. counterparts. Are you increasing your exposure there?

Sauer: We are primarily a U.S. manager, but we own
Accentureacn -0.46062733055494626%Accenture PLC Cl AU.S.: NYSEUSD90.76
-0.42-0.46062733055494626%
/Date(1425417960847-0600)/
Volume (Delayed 15m)
:
2288759
P/E Ratio
18.96652719665272Market Cap
59752781829.9763
Dividend Yield
2.2501654533421576% Rev. per Employee
106289More quote details and news »acninYour ValueYour ChangeShort position
[ACN], for instance, and it is based in Ireland.
Suncorsu.t 1.6990291262135921%Suncor Energy Inc.Canada: TorontoCAD37.71
0.631.6990291262135921%
/Date(1425417000000-0600)/
Volume (Delayed 15m)
:
1766574
P/E Ratio
19.89238803608166Market Cap
53557092693.5412
Dividend Yield
2.970034473614426% Rev. per Employee
2858310More quote details and news »su.tinYour ValueYour ChangeShort position
[SU] is Canadian. We are not precluded from investing outside the U.S. if we can find a company that meets our investment criteria and we have access to management. An example was last summer when we bought
Stanley Black & Deckerswk -0.49534977759805904%Stanley Black & Decker Inc.U.S.: NYSEUSD98.43
-0.49-0.49534977759805904%
/Date(1425417934981-0600)/
Volume (Delayed 15m)
:
447205
P/E Ratio
20.10719473027433Market Cap
15570601811.3904
Dividend Yield
2.116186794180486% Rev. per Employee
224972More quote details and news »swkinYour ValueYour ChangeShort position
[SWK]. Stanley bought a European security business, and investors worried about the increased exposure to that region, and the shares sold off and allowed us to take an oversized position. About 30% of its revenues now come from Europe. It's a great company with improving returns on invested capital, high and improving margins, and a great barrier to entry in its U.S. tool business. The power-tool business is about 50% of its business since Stanley merged with Black & Decker. It supplies
Home DepotHD -0.13778849466069584%Home Depot Inc.U.S.: NYSEUSD115.96
-0.16-0.13778849466069584%
/Date(1425417960590-0600)/
Volume (Delayed 15m)
:
2508483
P/E Ratio
26.20135746606335Market Cap
153026077921.278
Dividend Yield
2.037820568172006% Rev. per Employee
227879More quote details and news »HDinYour ValueYour ChangeShort position
[HD] and
Lowe'sLow -0.06658676255160474%Lowe's Cos.U.S.: NYSEUSD75.04
-0.05-0.06658676255160474%
/Date(1425417960015-0600)/
Volume (Delayed 15m)
:
2592592
P/E Ratio
27.68622232080145Market Cap
73055732990.4456
Dividend Yield
1.228402809303816% Rev. per Employee
214592More quote details and news »LowinYour ValueYour ChangeShort position
[LOW]. The rest of its business is 30% security, cameras and monitors for commercial buildings, and 20% industrial, fasteners and other parts. The management has a proven track record of adding value. We think a repricing will occur as it evolves more into an industrial company and not just a power-tool company, although revenues in the power-tool segment will benefit as housing continues to improve.

Tarkenton: Also, senior management's incentive-compensation program is tied directly to return on invested capital for the business. While we typically look for businesses that have high returns on invested capital, another great opportunity is finding a business that has arguably suboptimal returns on capital that are going to improve. If you look at the return on capital for Stanley Black & Decker the past three years, it started in the low teens. Each year, management's incentive compensation has been based on hitting higher and higher hurdles for return on invested capital.

How do you approach pruning the portfolio? Why did you sell Costco, for instance?

Tran: We bought
Costco Wholesale cost -0.3254021900770583%Costco Wholesale Corp.U.S.: NasdaqUSD147.4586
-0.4814-0.3254021900770583%
/Date(1425417951761-0600)/
Volume (Delayed 15m)
:
1095301
P/E Ratio
30.315051546391754Market Cap
65168162510.3857
Dividend Yield
0.965802432189787% Rev. per Employee
587123More quote details and news »costinYour ValueYour ChangeShort position
[COST] because it typically grows revenues by about 10% a year, driven by 5% same-store sales and 5% square-footage growth on average. Costco's net income is about exactly equal to their membership fees. So the way for them to grow net income is to grow members. We thought they could continue to do that because they had said they expected to double the store count in the U.S. Additionally, about 20% of their products are sold under their private-label Kirkland brand, which sells at a lower price point but generates higher margins. They had an opportunity to make the Kirkland brand a higher percentage of sales. Costco represented growth, improving margins, and improving return on capital. In 2008, the economic environment caused Costco to throttle back on their growth plans.

We fundamentally disagreed with management. We thought '08 provided an opportunity where real estate was cheap and they had capital to invest. They were in a unique position when they could have accelerated their growth. Yet they took the opposite tack. Their margin growth reversed when they dropped prices on their private-label products to wow their customers. We thought that was unnecessary.

Would you call yourselves activists?

Sauer: We're not activists in the sense that we are going to file proxies and demand board seats. We are active in that we have numerous conversations with management about strategy. If we disagree with a management's strategy, we will sell the stock.

Let's talk about what you have been attracted to more recently.

Tran: Robert Half Internationalrhi -0.589265806657111%Robert Half International Inc.U.S.: NYSEUSD62.42
-0.37-0.589265806657111%
/Date(1425417935439-0600)/
Volume (Delayed 15m)
:
343234
P/E Ratio
27.37280701754386Market Cap
8485503919.95942
Dividend Yield
1.2818458580355712% Rev. per Employee
20866.7More quote details and news »rhiinYour ValueYour ChangeShort position
[RHI] is a leading provider of temporary staffing, as well as permanent staffing in accounting. It is an asset-light model where they get paid for other people's labor. The return on capital is around 30%. Temporary hiring is a leading indicator of full-time employment, since a company will often hire a temp first and then a few quarters later make the person a full-timer. For 10 consecutive quarters, we've seen their temp business grow by double digits.

You've liked this one for a while, so what makes it stand out now? Have you been adding to it?

Tran: We have been adding to it. We are seeing a conversion now from temporary positions to permanent placements, for which they get a higher margin. Right now, accounting temps make up about 35% of their total revenues. Yet in downturns, Robert Half has tended to make investments and position itself in other areas, and in the 2008 to 2010 time frame they moved more into technical staffing, which is now about 10% to 11% of their revenues.

The tech-staffing market is four times greater than accounting, and so they have the ability to continue to grow by double digits for the foreseeable future. It is also a company where management does a very good job in capital allocation. Its trailing-free-cash-flow yield is 7% to 8%, it's growing in the midteens, and we are beginning to see an acceleration in some of their new markets.